Price-to-earning
Price-to-earnings ratio (P/E) is often used for assessing the company’s stock price. P/E is determined by first calculating the earnings per shares (EPS), which is the post-tax profits divides by the number of shares (Figure 1). Trailing P/E is equal to current market share price divided by trailing earnings per share for the past 12 months, whereas forward P/E is equal to current share price divided by expected earnings per shares for the next 12 months or next full-year fiscal period (http://www.investopedia.com assessed on 18/08/2012)
Earnings per shares (EPS) = (Post-tax profits)/(Number of shares)
Trailing P/E = (Current share price)/(Trailing earnings per shares for the past 12 months)
Forward P/E = (Current share price)/(Expected earnings per shares)
Figure 1: Calculation for P/E ratio and EPS.
The limitation of P/E ratio is that it does not indicate the growth prospects of the company’s EPS. If the P/E ratio is low for a company, then its stock price is undervalued. If the company has a high P/E ratio and is growing quickly, then the growth in EPS will eventually lower the P/E ratio. However, if the company has a high P/E ratio and is not growing, then the stock is overvalued (McClure, B., 2010). Therefore, it is difficult to determine if a high P/E is the consequence of expected growth or the stock is overpriced.
In addition, if the company has large intangible assets, such as patents and copyrights, then earning per shares may be lower. These intangible assets may not immediately earn money for the company, and cannot easily convert to money unless selling them. Moreover, if company spending millions of dollars in research and development (R&D), these R& D will take a number of years before products can be bring to market. The earning per shares during R& D period will be lower than when products are ready in market. Hence, the earnings per shares do not take into account on the forecast growth of the company.
Earnings per shares (EPS) = (Post-tax profits)/(Number of shares)
Trailing P/E = (Current share price)/(Trailing earnings per shares for the past 12 months)
Forward P/E = (Current share price)/(Expected earnings per shares)
Figure 1: Calculation for P/E ratio and EPS.
The limitation of P/E ratio is that it does not indicate the growth prospects of the company’s EPS. If the P/E ratio is low for a company, then its stock price is undervalued. If the company has a high P/E ratio and is growing quickly, then the growth in EPS will eventually lower the P/E ratio. However, if the company has a high P/E ratio and is not growing, then the stock is overvalued (McClure, B., 2010). Therefore, it is difficult to determine if a high P/E is the consequence of expected growth or the stock is overpriced.
In addition, if the company has large intangible assets, such as patents and copyrights, then earning per shares may be lower. These intangible assets may not immediately earn money for the company, and cannot easily convert to money unless selling them. Moreover, if company spending millions of dollars in research and development (R&D), these R& D will take a number of years before products can be bring to market. The earning per shares during R& D period will be lower than when products are ready in market. Hence, the earnings per shares do not take into account on the forecast growth of the company.